Returns of Stocks

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Investment Snapshot

* On the day Caterpillar announced record second-quarter
earnings in 2006, its stock price declined by 1.2 percent.
* Alcoa reported a 62 percent quarterly increase in net
income, and the stock price declined by a few dollars on
the day of the announcement.
* Citigroup reported an increase of 4 percent in quarterly
earnings, and the stock price did not change much on the
day of the announcement.

The Investment Snapshot illustrates that stock prices bear a relationship
to earnings, but in many cases the short-term relationship
can be quite volatile. The price that an investor is willing to pay for
a stock depends on the expected return from that stock, which is
the present value of both the cash flows from dividends and the
expected future selling price of the stock. When a company’s
earnings increase, the company can increase the dividends that it
pays as well as expand its retained earnings, thereby causing the
stock price to rise.

WHAT RETURNS CAN YOU EXPECT FROM STOCKS?

What is the rate of return that you can expect from your stocks?
The answer depends on many factors, one of which is the time
frame over which question is asked. If you ask the question during
a bull market, the rate of return is often quoted to be in the double
digits (above 10 percent), whereas during a bear market it is
in the 6 to 7 percent range. This discrepancy is not as important
as understanding how returns are made up and that stocks
generally outperform bonds and money market securities over
long holding periods. Professor Jeremy Siegel says that in every
10-year holding period from 1802, stocks outperformed bonds and
Treasury bills and that during the same holding period, the worst
performance of stocks was better than that of bonds and Treasury
bills (2002, p. 26). During short holding periods, stocks are riskier
than bonds and Treasury bills, but over long holding periods, the
returns from a portfolio of stocks exceed those of bonds and
Treasury bills.

Returns from stocks are from two sources: income in the
form of dividends (if the company pays dividends) and capital
appreciation. When companies are able to increase their earnings,
they can then raise the dividends they pay out to shareholders.
Companies do not pay out their entire earnings in dividends.
The amount of earnings retained (not paid out to shareholders)
is invested in the business to increase future earnings. Thus
shareholders of companies that do not pay dividends can benefit
when these companies grow their earnings. The disappointment
when companies fail to grow their earnings at expected rates
accounts for the decline in the prices of their stocks. This volatility
of stock prices over short periods results in fluctuating
returns for stocks, but over long holding periods, investors in
stocks are able to earn higher returns than those from bonds and
Treasury bills.

KEY CONCEPTS
* What returns can you expect from stocks?
* Calculating a rate of return
* Risk-return tradeoff
* Asset allocation and the selection of investments